The new breed of “smart-beta” exchange traded funds has quickly expanded as investors use alternative investment tools to diversify away from traditional market capitalization-weighted indices.
Smart-beta ETFs are based on factors that reconfigure standard market-cap indices into smart-beta indices, including equal weight, fundamental, value, momentum, quality and minimum volatility, among others, in what can be aptly called “factor indices,” writes Deborah Fuhr, Managing Partner at ETFGI, for Financial News. [‘Smart-Beta’ ETFs Provide Active Strategies in a Passive Wrapper]
The term “beta” refers to non-diversifiable risks of a market and expresses the volatility of returns compared to a large benchmark, like the S&P 500. It has a default value of 1.0.
Academic research has also found that alternative indexing methodologies, beyond traditional market-cap, have generated better returns with lower risk over long periods. Consequently, money managers and sponsors have been quick to adopt factor indices as a way to avoid the flaws in market-cap indices and shift away from inconsistent performance in active funds. [Some Smart Beta ETFs Draw Praise]
However, potential investors should be aware that factor index-based strategies tend to create biases, or a tilt toward certain stocks.